Towards a carbon-neutral economy: The dynamics of factor substitution in Germany

This paper investigates the elasticity of substitution between four inputs-capital, labor, energy, and material-with the translog cost approach for a wide range of industries in Germany by incorporating the slow adjustment process in factor substitution. To this end, we take advantage of EU KLEMS database covering a wide range of industries and consider two models. The first is the static model, in which instantaneous and complete substitution adjustments are assumed. The other model, referred to as dynamic, takes into account the slow adjustment process and applies this to the cost share equations which are estimated using Zellner's seemingly unrelated regression. The empirical results suggest that (i) the dynamic models have greater explanatory power than the static models; (ii) the production process at the national or industry level in Germany is mainly characterized by a complementarity or weak substitutability between energy and other inputs, which limits German government's ability to reduce energy use through factor substitution; (iii) among four factor prices, energy demand seems to be more sensitive to changes in the price of material, followed by labor. Hence, an increase in energy prices can be efficient to some extent in order to reduce energy use; (iv) there is a substantial industry heterogeneity in Germany in terms of both input substitution and its adjustment process. Therefore, strategies to mitigate CO2 emissions through input substitution channel should be designed at the industry level based on the industry-specific needs and peculiarities. It is because well-designed comprehensive policies that consider different structures of industries could help to achieve a carbon-neutral economy for Germany.