## CHAPTER 3 NEAR-TERM IMPACT OF DECARBONIZATION POLICIES — Annex

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---

### Purpose and scope of the annex
- Documents model structure, data sources, and simulation details for Chapter 3.
- Sections covered:
  - Structure and calibration elements of the Global Macroeconomic Model for the Energy Transition (GMMET).
  - Factor reallocation during the transition (Section 3.2).
  - External sector behavior during the transition (Section 3.3).
  - Impact of delayed climate policies for different regions (Section 3.4).
- GMMET configured for four regions: the United States, the euro area, China, and a rest-of-the-world block.
- Focus: short- and medium-term macroeconomic impacts of curbing GHG emissions over an eight-year horizon; excludes long-term productivity gains from evolving emissions-reduction technologies and excludes warming damage functions and avoided-warming benefits.

### Model class and core features
- Model classification and inheritance:
  - Multi-region, large-scale structural New-Keynesian dynamic general equilibrium model.
  - Macroeconomic core inherited from GIMF (Global Integrated Monetary and Fiscal Model).
- Key elements:
  - Tradable and non-tradable goods sectors.
  - Liquidity-constrained and overlapping-generations households (non-Ricardian behavior).
  - Real and nominal rigidities.
  - Fiscal sector with multiple instruments; simple monetary policy rule.
  - Financial sector with procyclical financial accelerator (borrowing costs rise with firms’ debt relative to net worth, as in Bernanke, Gertler and Gilchrist (1999)).
- Non-Ricardian implications:
  - Level of government debt affects region outcomes even in the long term (Blanchard 1985).
  - Permanent variations in current account balances and meaningful net foreign asset roles.
- Short- to medium-term focus reiterated: excludes prospective long-term productivity gains and warming damages.

### Energy sector structure and linkages
- Fossil fuel mining:
  - Three mining sectors: coal, gas, and oil; each combines capital and labor with a resource in fixed supply.
  - Calibration reproduces empirical supply elasticities at various horizons.
  - Mining supply elasticities determine incidence of GHG price burden across customers and consequent fuel switching.
- Markets:
  - Domestic markets for coal, gas, and oil.
  - International markets: oil modeled as integrated global market; gas modeled with bilateral trade. International trade in coal not modeled.
- Uses of fuels:
  - All three fuels sold to tradable sector as intermediate inputs.
  - Oil and gas consumed by households; gas and coal used for electricity generation.
- Electricity generation technologies:
  - Five technologies: coal, gas, nuclear, hydroelectric, and renewables; each has own capital stock and emission intensities.
  - Nuclear and hydro: investment exogenously decided.
  - Renewables intermittency captured via “renewables-plus-backup” utility pairing wind/solar with flexible gas backup; backup size endogenously determined by cost minimization.
  - Grid-scale electricity storage not modeled.
  - Electricity output paired with grid capital and combined into final electricity bundle with a very high elasticity of substitution.
- Transportation:
  - Distinguishes conventional cars (gasoline from oil) and electric vehicles (powered by electricity).
  - Net inflow to fleets = newly purchased minus scrapped cars.
  - Share of new purchases depends on relative vehicle prices and elasticity of substitution of 3.3, relative expected fuel costs over a car’s lifecycle, and charging/fueling network size (elasticity reference: Holland, Mansur and Yates 2021).
  - Network externalities between EV adoption and charging station deployment modeled, producing positive feedback amplifying electrification under mitigation policies.

### Household consumption and CPI treatment
- Cars treated as investment goods; fuels (gasoline or electricity) explicitly included in consumption bundle.
- CPI composition:
  - Core inflation excludes energy consumption (oil, gas and electricity).
  - Only cars and the final consumption good included in core inflation measure.
- Residential heating modeled as composite of electricity and gas.
- “Other goods and services” denotes standard GIMF consumption bundle.

### Production structure, abatement, and policy instruments
- Production:
  - Nontradable sector uses electricity plus capital and labor.
  - Tradables use capital and labor plus an energy bundle (electricity, oil, gas, coal).
  - Final good mixes nontradable, tradable production, and imported tradables; imported tradables share higher for investment than consumption.
- Abatement:
  - Non-fossil-fuel GHG emissions not modeled explicitly; tradables and nontradables can employ emission abatement technology that reduces emissions at the expense of total factor productivity.
  - Abatement implemented in reduced-form calibrated to sector-specific marginal abatement cost curves; sectors equate tax savings from abating a marginal unit to marginal abatement costs.
- Government policy instruments in GMMET:
  - Sector-specific per-unit GHG taxes dependent on sector carbon intensity.
  - Subsidies for green technologies (renewables, electric vehicles).
  - Expansion of public investment in nuclear power generation (government or government-financed).
  - Regulatory instruments modeled as revenue-neutral tax–subsidy combinations to mimic input-relative-quantity regulations.

### Calibration, data sources, and benchmark values
- Primary data sources:
  - OECD Inter-Country Input-Output Tables (OECD 2021).
  - World Energy Balances (IEA 2021).
  - EDGAR database for initial GHG emissions (European Commission Joint Research Centre 2022).
  - Marginal abatement costs for non-CO2 emissions calibrated from US EPA 2019 country-specific estimates.
- Region shares (GDP percent of world): China 16.4, Euro Area 15.5, Rest of the World 43.7, United States 24.4.
- Annex Table 3.1.1 — Fossil fuel supply and use (percent of region’s GDP, unless noted otherwise). Key entries:
  - Fossil fuel extraction: China 3.3, Euro Area 0.2, Rest of the World 6.1, United States 2.6.
    - Coal: China 2.5, Euro Area 0.2, Rest of the World 0.7, United States 0.3.
    - Fossil gas: China 0.2, Euro Area 0.0, Rest of the World 1.5, United States 0.8.
    - Oil: China 0.6, Euro Area 0.0, Rest of the World 4.0, United States 1.4.
  - Fossil fuel net imports: China 1.6, Euro Area 1.9, Rest of the World -1.5, United States 0.4.
    - Fossil gas: China 0.2, Euro Area 0.5, Rest of the World -0.2, United States -0.0.
    - Oil: China 1.4, Euro Area 1.4, Rest of the World -1.3, United States 0.5.
  - Fossil fuel in electricity: China 1.8, Euro Area 0.3, Rest of the World 1.1, United States 0.6.
    - Coal: China 1.7, Euro Area 0.1, Rest of the World 0.5, United States 0.3.
    - Fossil gas: China 0.1, Euro Area 0.2, Rest of the World 0.6, United States 0.3.
  - Energy in tradables: China 5.7, Euro Area 2.0, Rest of the World 3.9, United States 1.6.
    - Coal: China 0.8, Euro Area 0.0, Rest of the World 0.2, United States 0.0.
    - Fossil gas: China 0.2, Euro Area 0.2, Rest of the World 0.4, United States 0.3.
    - Oil: China 1.5, Euro Area 0.7, Rest of the World 1.7, United States 0.9.
    - Electricity: China 3.2, Euro Area 1.0, Rest of the World 1.6, United States 0.3.
  - Electricity in nontradables: China 0.3, Euro Area 0.8, Rest of the World 0.8, United States 0.5.
  - Energy in household consumption: China 1.3, Euro Area 1.5, Rest of the World 2.1, United States 1.8.
    - Fossil gas: China 0.1, Euro Area 0.1, Rest of the World 0.2, United States 0.1.
    - Oil: China 0.5, Euro Area 0.6, Rest of the World 0.9, United States 1.0.
    - Electricity: China 0.7, Euro Area 0.8, Rest of the World 1.0, United States 0.6.
- Benchmark and alternative elasticities (Annex Table 3.1.2):
  - Elasticity between four types of generation in electricity: Benchmark 20.0, Lower 5.0.
  - Elasticity between four types of energy in manufacturing: Benchmark 0.5, Lower 0.2.
  - Elasticity between energy and other factors in manufacturing: Benchmark 0.4, Lower 0.2.
  - Elasticity between electricity and other factors in services: Benchmark 0.5, Lower 0.2.
  - Elasticity between electricity and fossil gas in residential energy: Benchmark 1.5, Lower 1.2.
- Dynamic model parameters follow GIMF calibration; long-term elasticities of substitution between fossil fuels taken from literature (Fally and Sayre, 2018 cited).

### Nominal rigidities, Phillips curves, and monetary policy
- Inflation dynamics:
  - Linearized wage and price Phillips-type relations include past and expected future inflation and deviations of firms’ markups from equilibrium (notation μ̂t).
  - Default value of β is 0.97.
  - Lower central bank credibility scenario sets β = 0.2.
  - Wage inflation Phillips curve includes partial indexing of wage inflation to consumer price inflation.
- Monetary policy rule (log-linearized illustrative form):
  - it = ρ it−1 + (1 − ρ) αi [ (χ πt + (1 − χ) E(πt+1)) − π̄ ]
  - Inflation measure is a weighted average (using χ) of current and expected inflation; inflation series used can be headline or core inflation, depending on scenario.

### Nonlinearities and solution techniques
- Sources of nonlinearities:
  - Energy sector features (rising marginal abatement costs, linkages between GHG emissions and taxation).
  - Standard nonlinear investment and financial accelerator mechanisms.
  - Discontinuous-like behavior (e.g., coal output falling to almost zero while other sectors still adjust).
- Solution method:
  - Model attempts full nonlinear solution but may use partial numeric linearization due to computational constraints (example: solving 75 percent of a GHG price shock and approximating remainder).
  - Approach captures significant nonlinearities and allows solving permanent shocks.
  - Nonlinear behavior example: doubling the economy-wide GHG price can produce more than double impacts in some sectors.

### Annex 3.2 — Resources reallocation under rising GHG taxes: Overview
- Scenario: GHG taxes gradually introduced in all regions simultaneously to reduce GHG emissions by 25 percent in less than a decade.
- Tax levied proportionally to a fuel’s CO2 intensity, penalizing coal most.
- Policy Packages:
  - Policy Package 1: GHG price alone.
  - Policy Package 2: GHG price + renewables subsidies.
  - Policy Package 3: additional scenarios referenced.

### Sectoral contributions to emissions reductions
- Electricity generation:
  - Initial share of emissions (United States): 29 percent.
  - Electricity expected to represent between 45 and 59 percent of emissions reduction depending on the scenario (Policy Packages 1 to 3).
  - China: electricity accounts for a third of GHG emissions and around half of their reductions depending on the scenario.
  - Mechanism: rapid substitution of coal by renewables with gas backup.
  - Policy outcomes:
    - Policy Package 1: large reduction in coal generation and shift to renewables.
    - Policy Package 2: increases share of renewables by around 20 percentage points relative to Policy Package 1.
  - Conclusion: GHG price targeting coal plus renewable subsidies key to swift electricity-sector decarbonization.
- Other sectors:
  - Households prominent in the United States and the euro area (residential energy and individual transportation).
  - Manufacturing important in China and the rest of the world.
  - Emissions also fall via energy savings and deployment of abatement technologies.

### Investment and labor reallocation
- Capital reallocation:
  - Overall investment falls because capital and energy are generally complements.
  - Investment booms in expanding energy sectors (renewables generation, gas power plants, electricity grid) and drops in declining sectors (fossil fuel extraction, coal power plants).
  - Investment in non-energy tradables and nontradables usually drops as energy costs rise.
- Labor reallocation:
  - Labor shifts from declining to expanding sectors.
  - Revenue recycling matters:
    - Cutting labor taxes with increased GHG tax revenues leads to significant employment expansion in non-energy tradables and nontradables.
    - Lump-sum transfers of tax revenue to households lead to employment declines in those sectors.

### Regional heterogeneity and required GHG prices
- Regions require different GHG prices for the same proportional emissions reduction due to differing energy/economic structures.
- Representative values (Policy Package 1):
  - United States: 85 US dollars per metric ton of CO2 equivalent.
  - Euro area: 137 US dollars per metric ton of CO2 equivalent.
  - China: 36 US dollars per metric ton of CO2 equivalent.
  - Rest of the world: 95 US dollars per metric ton of CO2 equivalent.
- Drivers:
  - United States: high emissions-to-GDP ratio; easier reductions in electricity (abundant gas) and individual transportation (mature EV tech).
  - Euro area: lower emissions per unit of GDP after prior mitigation; fewer low-hanging fruits remain.
  - China: concentrated emissions in electricity and manufacturing; heavy coal use implies relatively low GHG price suffices.
  - Rest of the world: high share of energy in GDP, high oil use, large net exporter of fossil fuels → higher required GHG price and larger negative impact on real GDP and investment.

### International spillovers: common action versus partial action
- Common action (Policy Package 1 in all regions):
  - Global investment slows in near term, particularly in rest of the world; global real interest rate falls.
  - Capital flows out of rest of the world, depreciating its effective exchange rate and improving its trade balance.
  - Real effective exchange rates appreciate in the United States, the euro area and China.
- Partial action (only United States, euro area, and China implement Policy Package 1):
  - Global emissions reduction muted because rest of the world does not reduce fossil fuel demand; global oil and gas prices decline less.
  - Mitigating regions experience greater GDP losses because tax burden less offset by lower producer prices.
  - Rest of the world experiences spillovers (lower oil and gas prices and lower export demand) and more muted reduction in investment relative to common action.
  - Net effects:
    - Smaller reduction in global investment and only a small reduction in global interest rates relative to common action.
    - Smaller effective exchange rate appreciations in China, the euro area and the United States than under common action.
  - Region-specific impacts:
    - United States: investment slightly higher under partial action because fossil fuel extraction avoids a large decline.
    - Euro area: investment drops more rapidly under partial action (absence of U.S. fossil fuel channel).
    - China: investment still falls, driven by contraction of the coal sector.

### Delayed mitigation policies (Annex 3.4): scenarios and macro outcomes
- Comparison: immediate and gradual implementation of Policy Package 1 versus delayed and more abrupt implementation that targets same emissions reduction by 2030 and similar cumulative emissions by 2045.
- Delayed implementation consequences:
  - Requires steeper rise in GHG prices and temporarily higher levels to achieve same cumulative emissions by medium term.
  - Example GHG price paths in delayed scenario:
    - China: GHG price increases from 2027 to 2030 to reach 50 US dollar per metric ton of CO2 equivalent.
    - Euro area: GHG price climbs up to 200 US dollars in the euro area by 2030.
  - Emissions decline rapidly starting in 2027 to reach same level as under gradual implementation by about 2030; cumulative emissions converge by 2045.
- Macro outcomes:
  - Rushed mitigation after procrastination until 2026 greatly magnifies costs for the United States, the euro area and the rest of the world block.
  - Greater output-inflation tradeoff:
    - High output costs of stabilizing headline inflation (roughly same magnitude as under immediate mitigation).
    - High inflation when output losses are limited (about same as under immediate policy action).
  - Worst deterioration of output-inflation tradeoff occurs in the rest of the world.
  - China: both gradual and delayed mitigation generate little inflation because of low direct impact of GHG price on CPI and a drop in global fossil fuel prices; delayed, more abrupt policies further reduce China’s fossil fuel producer prices and further reduce inflation in China in the near term. China’s output-inflation tradeoff is smaller than in other regions.

*Source: CHAPTER 3 NEAR-TERM IMPACT OF DECARBONIZATION POLICIES — Annex (World Economic Outlook, October 2022).*

### CHAPTER 3 NEAR-TERM IMPACT OF DECARBONIZATION POLICIES

### CHAPTER 3 NEAR-TERM IMPACT OF DECARBONIZATION POLICIES

### Purpose and scope of the annex
- Documents the model structure, data sources, and additional details on simulations presented in Chapter 3.
- Sections covered in this annex:
  - Structure and calibration elements of the Global Macroeconomic Model for the Energy Transition (GMMET).
  - Factor reallocation during the transition (Section 3.2).
  - External sector behavior during the transition (Section 3.3).
  - Impact of delayed climate policies for different regions (Section 3.4).
- GMMET is configured for four regions: the United States, the euro area, China, and a rest-of-the-world block.

### Model class and core features
- GMMET classification:
  - Multi-region, large-scale structural New-Keynesian dynamic general equilibrium model.
  - Macroeconomic core inherited from GIMF (Global Integrated Monetary and Fiscal Model).
- Key model elements:
  - Tradable and non-tradable goods sectors.
  - Liquidity-constrained and overlapping-generations households (implying non-Ricardian behavior).
  - Real and nominal rigidities.
  - Fiscal sector with a variety of fiscal instruments.
  - Simple monetary policy rule.
  - Financial sector with a procyclical financial accelerator (borrowing costs rise with firms’ debt relative to net worth, as in Bernanke, Gertler and Gilchrist (1999)).
- Non-Ricardian implications:
  - Level of government debt affects region outcomes even in the long term (Blanchard 1985).
  - Permanent variations in current account balances and meaningful net foreign asset roles.
- Short- to medium-term focus:
  - Purpose is to analyze short- and medium-term macroeconomic impacts of curbing GHG emissions over an eight-year horizon.
  - GMMET excludes prospective long-term productivity gains from evolving emissions-reduction technologies and excludes warming damage functions and avoided-warming benefits.

### Energy sector structure and linkages
- Fossil fuel mining sectors:
  - Three mining sectors: coal, gas, and oil.
  - Each combines capital and labor with a resource in fixed supply.
  - Calibration reproduces empirical supply elasticities at various horizons (coal elasticity example referenced in Boer, Pescatori and Stuermer (2021)).
  - Mining supply elasticities determine incidence of GHG price burden across customers and consequent fuel switching.
- Markets:
  - Domestic markets for all three fuels.
  - International markets modeled for oil (integrated global market tracking each region’s total exports and imports) and gas (bilateral trade tracking among regions).
  - International trade in coal is not modeled due to low observed trade shares.
- Uses of fuels:
  - All three fuels sold to tradable sector as intermediate inputs.
  - Oil and gas consumed by households (gasoline and home heating).
  - Gas and coal sold as fuel for electricity generation.
- Electricity generation technologies:
  - Five technologies: coal, gas, nuclear, hydroelectric, and renewables.
  - Technologies differ in cost structures and emission intensities; each has its own capital stock.
  - Nuclear and hydro grouped with exogenously decided investment (political/site constraints).
  - Renewables intermittency captured via a “renewables-plus-backup” utility that pairs wind/solar with flexible gas backup; size of backup determined endogenously by cost minimization.
  - Grid-scale electricity storage is not modeled (based on currently available technology).
  - Electricity output from all technologies paired with grid capital and combined into a final electricity bundle with a very high elasticity of substitution.
- Transportation sector:
  - Distinguishes fleets of conventional cars (gasoline from oil) and electric vehicles (powered by electricity).
  - Net inflow to fleets = newly purchased minus scrapped cars.
  - Share of new purchases depends on relative vehicle prices and elasticity of substitution of 3.3, relative expected fuel costs over a car’s lifecycle, and charging/fueling network size (elasticity reference: Holland, Mansur and Yates 2021).
  - Network externalities between electric vehicle adoption and charging station deployment modeled (in the spirit of Li and others 2017), producing a positive feedback loop amplifying electrification under mitigation policies.

### Household consumption and CPI treatment
- Cars treated as investment goods to reflect high import share; fuels (gasoline or electricity) explicitly included in consumption bundle.
- Consumer price index (CPI) composition:
  - Core inflation excludes energy consumption (oil, gas and electricity).
  - Only cars and the final consumption good are included in the core inflation measure.
- Residential heating modeled as a composite of electricity and gas.
- “Other goods and services” denotes the standard GIMF consumption bundle (final good made up of tradable and nontradable goods).

### Production structure, abatement, and policy instruments
- Nontradable (mostly services) sector uses electricity plus capital and labor.
- Tradables (mostly manufacturing) use capital and labor plus an energy bundle comprising electricity, oil, gas, and coal.
- Final good is a combination of nontradable, tradable production, and imported tradables; imported tradables share is higher for investment than consumption.
- Non-fossil-fuel GHG emissions (e.g., methane from agriculture) are not modeled explicitly:
  - Tradables and nontradables can employ emission abatement technology that reduces emissions at the expense of total factor productivity.
  - Abatement implemented in reduced-form calibrated to sector-specific marginal abatement cost curves; sectors equate tax savings from abating a marginal unit to marginal abatement costs.
- Government policy instruments in GMMET:
  - Sector-specific per-unit GHG taxes dependent on sector carbon intensity.
  - Subsidies for green technologies (renewables, electric vehicles).
  - Expansion of public investment in nuclear power generation (modeled as government or government-financed decisions).
  - Regulatory instruments modeled as revenue-neutral tax–subsidy combinations to mimic input-relative-quantity regulations.

### Calibration, data sources, and benchmark values
- Primary data sources:
  - OECD Inter-Country Input-Output Tables (OECD 2021) for sector sizes and trade structure in the initial state.
  - World Energy Balances (IEA 2021) for granular fossil fuel calibration.
  - EDGAR database for initial GHG emissions (European Commission Joint Research Centre 2022).
  - Marginal abatement costs for non-CO2 emissions calibrated from US EPA 2019 country-specific estimates.
- Region shares (as reported):
  - GDP (percent of world): China 16.4, Euro Area 15.5, Rest of the World 43.7, United States 24.4.
- Annex Table 3.1.1 — Fossil fuel supply and use (percent of region’s GDP, unless noted otherwise). Key entries (as provided):
  - Fossil fuel extraction: China 3.3, Euro Area 0.2, Rest of the World 6.1, United States 2.6.
    - Coal: China 2.5, Euro Area 0.2, Rest of the World 0.7, United States 0.3.
    - Fossil gas: China 0.2, Euro Area 0.0, Rest of the World 1.5, United States 0.8.
    - Oil: China 0.6, Euro Area 0.0, Rest of the World 4.0, United States 1.4.
  - Fossil fuel net imports: China 1.6, Euro Area 1.9, Rest of the World -1.5, United States 0.4.
    - Fossil gas: China 0.2, Euro Area 0.5, Rest of the World -0.2, United States -0.0.
    - Oil: China 1.4, Euro Area 1.4, Rest of the World -1.3, United States 0.5.
  - Fossil fuel in electricity: China 1.8, Euro Area 0.3, Rest of the World 1.1, United States 0.6.
    - Coal: China 1.7, Euro Area 0.1, Rest of the World 0.5, United States 0.3.
    - Fossil gas: China 0.1, Euro Area 0.2, Rest of the World 0.6, United States 0.3.
  - Energy in tradables: China 5.7, Euro Area 2.0, Rest of the World 3.9, United States 1.6.
    - Coal: China 0.8, Euro Area 0.0, Rest of the World 0.2, United States 0.0.
    - Fossil gas: China 0.2, Euro Area 0.2, Rest of the World 0.4, United States 0.3.
    - Oil: China 1.5, Euro Area 0.7, Rest of the World 1.7, United States 0.9.
    - Electricity: China 3.2, Euro Area 1.0, Rest of the World 1.6, United States 0.3.
  - Electricity in nontradables: China 0.3, Euro Area 0.8, Rest of the World 0.8, United States 0.5.
  - Energy in household consumption: China 1.3, Euro Area 1.5, Rest of the World 2.1, United States 1.8.
    - Fossil gas: China 0.1, Euro Area 0.1, Rest of the World 0.2, United States 0.1.
    - Oil: China 0.5, Euro Area 0.6, Rest of the World 0.9, United States 1.0.
    - Electricity: China 0.7, Euro Area 0.8, Rest of the World 1.0, United States 0.6.
- Benchmark and alternative elasticities (Annex Table 3.1.2). Values provided exactly:
  - Elasticity between four types of generation in electricity: Benchmark 20.0, Lower 5.0.
  - Elasticity between four types of energy in manufacturing: Benchmark 0.5, Lower 0.2.
  - Elasticity between energy and other factors in manufacturing: Benchmark 0.4, Lower 0.2.
  - Elasticity between electricity and other factors in services: Benchmark 0.5, Lower 0.2.
  - Elasticity between electricity and fossil gas in residential energy: Benchmark 1.5, Lower 1.2.
- Dynamic model parameters follow GIMF calibration; long-term elasticities of substitution between fossil fuels (where no gradual modeling is used) taken from literature (Fally and Sayre, 2018 cited).

### Nominal rigidities, Phillips curves, and monetary policy
- Inflation dynamics:
  - Represented (for illustrative purposes) with linearized wage and price Phillips-type relations including past and expected future inflation and deviations of firms’ markups from equilibrium (notation uses μ̂t).
  - Default value of β is 0.97.
  - Scenario with lower central bank credibility sets β = 0.2, introducing more sluggish inflation expectations.
  - Wage inflation Phillips curve includes partial indexing of wage inflation to consumer price inflation.
- Monetary policy rule (log-linearized illustrative form):
  - it = ρ it−1 + (1 − ρ) αi [ (χ πt + (1 − χ) E(πt+1)) − π̄ ]
  - Measure of inflation is a weighted average (using χ) of current and expected inflation; the inflation series used can be headline or core inflation, depending on the scenario.

### Nonlinearities and simulation techniques
- Model nonlinearities arise from:
  - Energy sector features (rising marginal abatement costs, linkages between GHG emissions and taxation).
  - Standard nonlinear investment and financial accelerator mechanisms.
  - Discontinuous-like behavior (e.g., coal output falling to almost zero while other sectors still adjust), producing discontinuities in the mathematical solution.
- Solution method:
  - Attempts to solve the full nonlinear model but may partially approximate the solution due to computational constraints.
  - Partial numeric linearization can be used (for example, solving 75 percent of a GHG price shock and approximating remainder from nearby solutions).
  - This approach captures significant nonlinearities and allows solving permanent shocks (such as permanent increases in GHG taxation) rather than being limited to temporary shocks.
  - Nonlinear solution behavior example: doubling the economy-wide GHG price can produce more than double impacts in some sectors, which would be lost under linear approximation.

*Source: CHAPTER 3 NEAR-TERM IMPACT OF DECARBONIZATION POLICIES — Annex (World Economic Outlook, October 2022).*

### Annex 3.2 Resources Reallocation under Rising GHG Taxes

### Annex 3.2 Resources Reallocation under Rising GHG Taxes

### Overview
- Scenario focus: GHG taxes gradually introduced in all regions simultaneously to reduce GHG emissions by 25 percent in less than a decade.
- Key mechanism: Tax levied proportionally to a fuel’s CO2 intensity, penalizing coal the most.
- Policy Packages referenced: Policy Package 1 (GHG price alone), Policy Package 2 (adds renewables subsidies), Policy Package 3 (additional scenarios referenced).

### Sectoral contributions to emissions reductions
- Electricity generation
  - Initial share of emissions (United States): 29 percent.
  - Electricity expected to represent between 45 and 59 percent of emissions reduction depending on the scenario (Policy Packages 1 to 3).
  - China: electricity accounts for a third of GHG emissions and around half of their reductions depending on the scenario.
  - Mechanism: rapid substitution of coal by renewables with gas backup to compensate for intermittency.
  - Policy outcomes:
    - Policy Package 1 incentivizes a large reduction in coal generation and a shift to renewables.
    - Policy Package 2 (GHG price + renewables subsidies) increases the share of renewables by around 20 percentage points relative to Policy Package 1.
  - Conclusion: Combination of a GHG price (heavily targeting coal) and renewable subsidies is key to swift and effective electricity-sector decarbonization.
- Other sectors
  - Households: prominent role in the United States and the euro area because residential energy and individual transportation account for a large share of emissions.
  - Manufacturing: particularly relevant for emissions reductions in China and the rest of the world.
  - Emissions fall elsewhere via energy savings and deployment of abatement technologies (shifting to lower-emission processes).

### Investment and labor reallocation
- Capital reallocation
  - Overall investment falls to adjust capital stocks because capital and energy are generally complements in production.
  - Heterogeneity: investment booms in expanding energy sectors (renewables generation, gas power plants, electricity grid) and drops in declining energy sectors (fossil fuel extraction, coal power plants).
  - Investment in non-energy tradables and nontradables usually drops as the cost of energy is higher.
- Labor reallocation
  - Labor shifts from declining to expanding sectors.
  - Revenue recycling matters:
    - Cutting labor taxes with increased GHG tax revenues leads to significant employment expansion in non-energy tradables and nontradables.
    - Lump-sum transfers of tax revenue to households lead to employment declines in those sectors.

### Regional heterogeneity and required GHG prices
- Different regions require region-specific GHG prices for the same proportional emissions reduction because of differing economic and energy structures.
- United States
  - High emissions-to-GDP ratio.
  - Easier reductions in electricity (abundant gas) and individual transportation (larger emissions share; more mature electric vehicle technology).
- Euro area
  - Lower emissions per unit of GDP after two decades of mitigation policies; fewer low-hanging fruits remain.
  - Example GHG prices in Policy Package 1: 137 US dollars per metric ton of CO2 equivalent (euro area) versus 85 US dollars per metric ton of CO2 equivalent (United States).
- China
  - High emissions-to-GDP ratio driven by concentrated emissions in electricity generation and manufacturing; household sector plays a relatively minor role.
  - Heavy use of coal implies a relatively low GHG price suffices: 36 US dollars per metric ton of CO2 equivalent in Policy Package 1 is sufficient to bring about the 25 percent overall emissions reduction.
- Rest of the world (aggregate block)
  - High share of energy in GDP, high share of oil use, large net exporter of fossil fuels.
  - Requires a higher GHG price: 95 US dollars per metric ton of CO2 equivalent in Policy Package 1.
  - Result: larger negative impact on real GDP and investment due to large increase in energy prices and high share of energy in production.

### International spillovers: common action versus partial action
- Common action (Policy Package 1 implemented in all regions)
  - Global outcome: investment slows in the near term, particularly in the rest of the world block, and the real global real interest rate falls.
  - Capital flows out of the rest of the world, depreciating its effective exchange rate and improving its trade balance.
  - Real effective exchange rates appreciate in the United States, the euro area and China.
- Partial action (only United States, euro area, and China implement the policy package)
  - Global emissions reduction is more muted because the rest of the world does not reduce fossil fuel demand; global oil and gas prices decline less.
  - Regions that engage in mitigation experience greater GDP losses because the tax burden is less offset by lower producer prices.
  - Rest of the world experiences only spillovers (lower oil and gas prices and lower demand for exports) and a more muted reduction in investment relative to common action.
  - Result: smaller reduction in global investment and only a small reduction in global interest rates relative to common action.
  - Effective exchange rate appreciations in China, the euro area and the United States are smaller than under common action.
  - Region-specific impacts:
    - United States: investment slightly higher under partial action because the fossil fuel extraction industry avoids a large decline in output due to higher demand for oil and gas.
    - Euro area: investment drops more rapidly under partial action (absence of the U.S. fossil fuel channel).
    - China: investment still falls, driven by contraction of the coal sector, which continues under partial action.

### Delayed mitigation policies (Annex 3.4)
- Comparison: immediate and gradual implementation of Policy Package 1 versus delayed and more abrupt implementation that keeps the same emissions reduction objective by 2030 and targets similar cumulative emissions by 2045.
- Delayed implementation consequences
  - Requires a steeper rise in all regions’ GHG prices and temporarily higher levels to achieve the same cumulative emissions reduction by the medium term.
  - Example GHG price paths in the delayed scenario:
    - GHG price increases from 2027 to 2030 to reach 50 US dollar per metric ton of CO2 equivalent in China.
    - GHG price climbs up to 200 US dollars in the euro area by 2030.
  - Emissions decline rapidly starting in 2027 to reach the same level as under gradual implementation by about 2030; cumulative emissions reductions converge by 2045.
- Macro outcomes
  - Rushed mitigation after procrastination until 2026 greatly magnifies costs for the United States, the euro area and the rest of the world block.
  - Greater output-inflation tradeoff: high output costs of stabilizing headline inflation (with roughly the same magnitude as under immediately implemented mitigation policies), and high inflation when output losses are limited (about the same as under immediate policy action).
  - The most extreme deterioration of the output-inflation tradeoff occurs in the rest of the world.
  - China: both gradual and delayed mitigation generate little inflation because of a low direct impact of the GHG price on the CPI (energy use is low outside manufacturing) and a drop in global fossil fuel prices; delayed, more abrupt policies further accentuate the drop in China’s fossil fuel producer prices and further reduce inflation in China in the near term. China’s output-inflation tradeoff is smaller than in other regions.

*Source: Annex 3.2, “Resources Reallocation under Rising GHG Taxes,” ch3annex - Annex 3.2 Resources Reallocation under Rising GHG Taxes (PDF).*

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_Source: https://www.imf.org/-/media/files/publications/weo/2022/october/english/ch3annex.pdf_