Climate Policies and Input Substitution: Short vs. Long Run

As the world grapples with climate change, one of the big questions is how we can effectively reduce carbon emissions without crippling our economy. This is where climate policies, like carbon taxes, come into play. But how do these policies affect the economy in the short term versus the long term? In this chapter, Mohammadreza (with co-author Stefan Hinkelmann) sheds light on this by exploring how quickly we can transition from fossil fuels to green alternatives.

In the short run, the options to replace fossil fuels with greener energy are pretty limited. However, over time, the ability to make this switch grows significantly. This means that while reducing energy use is tough at first, it becomes easier as we adopt better technologies. Mohammadreza and Stefan also reveal that to meet emission targets, carbon taxes might need to be set about 10% higher than previously thought if we only consider the long-term effects. Interestingly, the economic costs of implementing these higher taxes are minimal, particularly in the short run. What matters more than switching from one fuel type to another is reducing the overall energy intensity of the economy.

The Decline in Energy Intensity: Technological Advances Lead the Way

Energy intensity, which measures the amount of energy used per unit of economic output, has dropped dramatically in the U.S. over the last 50 years. But what’s behind this decline? And can we expect it to continue?

This trend isn’t just due to shifts in the economy, like the move from manufacturing to services. In fact, without these sectoral shifts, energy intensity would have fallen even more, by an additional three percent. The main driver behind the reduction is technological advancement, which accounts for over half of the decrease. Moreover, as our economy moves toward greater electrification, this trend is expected to persist. Mohammadreza has modeled various energy types to better understand this shift, providing deeper insights into how different energy sources contribute to the ongoing decline in energy intensity.

Climate Risk: The Dual Threat of Transition and Physical Risks

When it comes to climate change, businesses face two main types of risks: transition risks and physical risks. Transition risks come from the shift to a low-carbon economy—like stricter regulations and changing market dynamics. Physical risks, on the other hand, stem from the direct impacts of climate change, such as extreme weather events.

In this comprehensive chapter, Mohammadreza analyzed data from thousands of U.S. companies between 2002 and 2023 to develop a Climate Risk Index (CRI). The results? Transition risks are the biggest climate-related threats that firms face, followed by the physical impacts of climate change. The energy sector is particularly vulnerable, but agriculture, transportation, and real estate are also at high risk.

A path forward: Balancing Policy and Progress

Mohammadreza’s research offers valuable insights into the complex interactions between energy, climate policies, and the economy. His work highlights the importance of considering both short-term and long-term effects when designing climate policies, as well as the critical role of technological advancements in reducing energy intensity. As we continue to confront the challenges of climate change, such research provides essential guidance for building a more resilient and sustainable future.

Mohammadreza will defend his thesis on Friday September 20.

Click here for more information on the defense.

Click here to read the thesis in full.