Transitioning towards a low-carbon economy in Mexico: an application of the ThreeME model

This document offers an empirical application of the notion of energy transition to the Mexican economy and it takes the next step of simulating medium- and long-term impacts of proposed and future energy and fiscal policy on the environment and the Mexican economy. The starting point of the analysis is the ThreeME framework, a Multi-sectoral Macroeconomic Model based on Keynesian theory. It is designed to address the dynamics of global economic activity, energy system development and carbon emissions causing climate change. The ThreeME model is wellsuited for policy assessment purposes in the context of developing economies as it informs the transitional effects of policy intervention. In particular, disequilibrium can arise in the form of involuntary unemployment, the inertia of technical systems and rigidity in labor and energy markets as a result of delayed market clearing in the goods markets and slow adjustment between prices and quantities over the simulation time path.

Calibrated to updated sectoral and aggregated national accounts data, a Mexican version of the ThreeME has been developed and accounts for 24 commodities – including 3 energy sources – and 32 sectors, with an explicit distinction between 11 energy sectors and 7 transport sectors. Electricity production is disaggregated into 9 technologies: hydro, geothermal, wind, solar, biomass, nuclear, coal-based, oil-based and gas-based. The ThreeME-Mexico model is used to gauge the economic and environmental effects of energy and fiscal policy measures in Mexico (namely the phasing-out of energy subsidies and the implementation of a carbon tax). Different policy scenarios are assessed, each reflecting a different strategy of fiscal revenue recycling. We consider fiscal policy (in the form of carbon taxation) for Mexico’s energy transition and simulate how alternative government schemes for transferring tax revenues impact the Mexican economy and its carbon emissions. The level of the carbon tax is endogenously computed to meet the national emissions reduction targets set out in Mexico’s Climate Change Law.

In line with a scenario that we name the “IDEAL scenario”, we consider emission cuts of 40% by 2030 and 50% by 2050, as compared with the baseline and 2000 levels respectively. This requires carbon tax to reach US$100/tCO2 in 2030 and US$700/tCO2 in 2050. We take the case of no tax compensation for this first scenario. Because of substitution effects in energy-intensive production inputs and consumption goods, the policy successfully reduces CO2 emissions by 75% by 2050 with respect to the baseline or business-as-usual (BAU) scenario. But the environmental goal is achieved at a very high economic cost, with GDP dropping approximately 8% after 2040 compared to the reference scenario.

We then test the hypothesis of a full redistribution of carbon tax revenues among consumers (by reducing household income tax) and producers (by compensating for social security payroll taxes), which appears to be a way of reconciling environmental and economic goals. It is shown that this pattern of revenue transfer has beneficial impacts both on GDP and CO2 emissions reduction. With respect to the no-redistribution scenario, the gains on emissions reduction are slightly lower (a 72% as opposed to a 75% decrease in emissions) because of rebound effects: increased economic activity from redistribution leads to enhanced production and consumption, which ultimately drives up energy use. Our results support the notion that promoting a carbon tax is compatible with both environmental and economic gains.

Sensitivity tests are undertaken, including the utilization of alternative parameter values for the alternative substitution mechanisms. It is found that CO2 emissions reduction is low when the elasticity of substitution between capital and energy is constant (in absence of endogenous energy efficiency) and when the elasticity of substitution across types of commodities is low. Moreover, the economic gains from the tax crucially depend on the inflationary pressure resulting from the taxation policy (and therefore on the wage-setting process) and on the responsiveness of Mexico’s economy to foreign competition.

This document is the result of a two-year research collaboration involving the Mexican National Institute of Ecology and Climate Change (INECC), the French Economic Observatory (OFCE) and Agence Française de Développement (AFD).