Abstract
Climate change must deal with two market failures: global warming and learning by doing in renewable use. The first-best policy consists of an aggressive renewables subsidy in the near term and a gradually rising and falling carbon tax. Given that global carbon taxes remain elusive, policy makers have to use a second-best subsidy. In case of credible commitment, the second-best subsidy is set higher than the social benefit of learning. It allows the transition time and peak warming close to first-best levels at the cost of higher fossil fuel use (weak Green Paradox). If policy makers cannot commit, the second-best subsidy is set to the social benefit of learning. It generates smaller weak Green Paradox effects, but the transition to the carbon-free takes longer and cumulative carbon emissions are higher. Under first-best and second best with pre-commitment peak warming is 2.1 - 2.3 °C, under second best without commitment 3.5°C, and without any policy temperature 5.1°C above pre-industrial levels. Not being able to commit yields a welfare loss of 95% of initial GDP compared to first best. Being able to commit brings this figure down to 7%.
Highlights
Climate policy has to deal with two crucial market failures: the failure for markets to price carbon to fully internalize all future damages arising from burning another unit of carbon today (e.g., Nordhaus 2008; Stern 2013) and the failure of markets to internalize the full benefits of learning by doing in the production of renewable energy (e.g., Goulder and Mathai 2000; De Zwaan et al 2002; Popp 2004; Edenhofer et al 2005)
To correct for these market failures the first-best policy has to be two-pronged: a carbon tax that must be set to the social cost of carbon (SCC) which equals the present value of all future marginal global warming damages resulting from burning one extra unit carbon today,1 and a renewable subsidy that must be set to the social benefit of learning by doing (SBL) which equals the present value of all future reductions in the cost of renewables from using one unit of renewable energy today
Policy makers renege on their announcements by subscribing to more ambitious climate targets: the subsidy for renewable energy is increased by almost 10% to 50 $/tC and as a result cumulative carbon emissions are depressed by nearly 15 GtC as the linkage to the weak Green Paradox effect with higher fossil fuel use in the first 25 years is severed
Summary
Climate policy has to deal with two crucial market failures: the failure for markets to price carbon to fully internalize all future damages arising from burning another unit of carbon today (e.g., Nordhaus 2008; Stern 2013) and the failure of markets to internalize the full benefits of learning by doing in the production of renewable energy (e.g., Goulder and Mathai 2000; De Zwaan et al 2002; Popp 2004; Edenhofer et al 2005). To investigate how well a second-best Markov-perfect optimal subsidy for renewable energy production performs in the absence of a carbon tax in the decentralized market economy compared with the first-best climate policy and business as usual. Kalkuhl et al (2013) use a sophisticated IAM of growth and climate change with stock-dependent fossil fuel extraction costs to investigate the impact of optimal second-best renewable energy subsidies when carbon taxation is infeasible in a decentralized market. Policy makers can improve on the Markov-perfect second-best optimal renewable subsidy by pushing the subsidy above the SBL, thereby compensating for the lack of a carbon tax The extra term in the denominator is included to capture potentially catastrophic losses at high temperatures.
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