Financing the Fossil Fuel Phase-Out

Abstract

This paper models how key technological and financial aspects of a potential fossil fuel phase-out interact in a stylized setting. In the energy generation part of the model, the substitutability between green and dirty energy is endogenized such that firms can invest into substitutability enhancing infrastructure that allows for a fossil fuel phase-out to take place for reasonable carbon tax schedules. We find that, if substitutability improvements in the final energy generation process, involving green and dirty energy, are physically and economically feasible, there will be a technological tipping point that is triggered at some level of climate policy (carbon price or green energy subsidies) after which a rapid decarbonization of the energy sector becomes possible. Equipped with this mechanism for phasing out the fossil fuel sector, we consider the financial implications of key stylized facts, like the high capital intensity of renewables, and find that, in the presence of performance-based lending, the need for a fast accumulation of green capital during the transition can slow down the phase-out and can potentially lead to financial instability. To ensure a swift and robust transition, direct supportive policy measures for renewables can be used, which, depending on technological developments, might need to be permanent.

Keywords: endogenous elasticity of substitution, fossil fuel phase-out, climate policy, capital structure, economies of scale, performance-based lending, financial instability

JEL Classification: G11, G32, L16, O30, Q48, Q42