Reducing the cost of delay: on the interaction of cap-and-trade and subsidies for clean energy

Abstract

Relying on analytical and numerical modeling, I show that subsidies for clean energy can be welfare enhancing when a cap-and-trade (CAT) program is in place and if there is only the carbon externality. The growth rate of the permit price in the CAT program is too high if intertemporal permit trading is unconstrained implying too low prices and too high emission levels early on. Subsidies shift emissions to the future and thus, reduce carbon damage during the transition to carbon neutrality. The optimal subsidy path does not directly affect the permit price, but it is not time-consistent. The time-consistent subsidy has a direct permit price-reducing effect but is still welfare enhancing compared to a CAT-only policy. Subsidies also affect the regulator’s choice of the cap and reduce the permit price volatility. Overall, subsidies can be a reasonable second-best alternative if more efficient instruments are not available.

Keywords: cap-and-trade, renewable support, subsidies, carbon pricing

JEL Classification: D62, D92, H23, Q48, Q58