Navigating Geopolitical Crises for Energy Security: Evaluating Optimal Subsidy Policies via a Markov Switching DSGE Model

Published on February 1, 2024

Authored by Hong Zhao, Maria Teresa Punzi, Ying Tung Chan

How can policymakers design optimal subsidy policies that enhance energy security in the face of energy disruptions caused by geopolitical conflicts? This paper aims to answer this question, addressing the shortcomings of existing integrated assessment models for environmental evaluation that do not adequately account for the environmental and economic impacts of geopolitical conflicts and do not sufficiently prioritise energy security in policymaking.

We introduce a novel Markov switching dynamic stochastic general equilibrium (MS-DSGE) model and apply it to the case of the conflict between Russia and Ukraine, which posed a serious threat to the energy security of many European countries. Our results show that such disruptions can lead to significant decreases in output, social welfare, and energy consumption. Furthermore, we find that the mere anticipation of an energy crisis influences household behaviours, leading to a reduction in energy, output, and consumption volatility, while concurrently increasing volatility in social welfare.

To tackle these challenges, this paper proposes an optimal subsidy policy that incorporates energy security considerations. We show that this policy should be contingent upon productivity levels, energy imports, and the economy’s responsiveness to economic shocks. Additionally, we demonstrate that the policy should be adaptable to prevailing economic conditions and the likelihood of an upcoming crisis.