Reducing the Cost of Delay: On the Interaction of Cap-and-Trade and Subsidies for Clean Energy

Abstract

Relying on theoretical and numerical modeling I show that subsidies for clean energy can be welfare enhancing even if a cap-and-trade (CAT) program is already 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 early on. Without affecting the permit price, optimal subsidies shift some of the resulting excessive emissions to the future and thereby postpone carbon damages. However, the optimal subsidy path is not time consistent. The Markovian subsidy has a permit price reducing effect but is still welfare enhancing compared to a CAT-only policy. Subsidies also reduce the permit price volatility and stabilize the abatement path. In this sense, subsidies can be a reasonable second-best alternative if ideal CAT programs (e.g. with permit price collars) are not available.