How Constant is Constant Elasticity of Substitution? Endogenous Substitution between Clean and Dirty Energy

The degree of substitutability between clean and dirty energy plays a centralrole in leading economic analyses of optimal environmental policy. Despitethe importance, assuming a constant and exogenous elasticity of substitutionhas been a dominant theoretical approach. We challenge this assumption bydeveloping a dynamic general equilibrium model with an endogenous elasticityof substitution that interacts with the relative share of clean inputs in theeconomy. We find strong dynamic feedback effects arising from endogenoussubstitution capacity that amplifies the impact of directed technical changeand accelerates the transition to a green economy