E-DSGE model with endogenous capital utilization rate

Environmental policy research has increased due to stricter policies aligned with climate goals. However, to achieve the goal of net-zero emissions, the adoption of even stronger policies and increased carbon taxes is necessary, with transition risk becoming a major concern for companies. Even though governments worldwide have been employing a range of methods such as carbon tax, cap-and-trade, and intensity targets to mitigate the impact of climate change, a pivotal debate around determining the optimal policy that reduces emissions without harming the economy continues. Our paper delves into the environmental policy assessment emphasizing the role of endogenous capital utilization rates, which have hitherto been largely disregarded in literature. We study how endogenous capital utilization rate affects the transmission mechanism of economic shocks and the optimal environmental policy choice. To evaluate the quantitative impact of the transmission mechanism, we introduce distinct features to the environmental-dynamic stochastic general equilibrium (E-DSGE) model, including endogenous capital utilization, time-varying depreciation of capital, and environment quality shocks. We find that the complementarity between energy and capital leads to an amplification effect of the conventional transmission mechanism. Our model with these ingredients ranks any carbon tax below 25% as the best policy in terms of welfare improvement.