Optimal timing of phasing out producer subsidies towards carbon neutrality: Interaction between fossil energy extraction and environmental uncertainties

Abstract

Since subsidies for fossil-fuel producers entail “carbon locked-in” risks, phasing out the subsidies is widely agreed to be critical for progress on climate change towards carbon neutrality. However, due to the uncertainties and irreversibilities associated with environmental degradation and economic losses, delaying removal efforts allows us to benefit from cheaper abatement options and less total abatements owning to self-regeneration of pollution stock. Therefore, whether the removal action should be taken currently or be delayed becomes vital for policy making. We develop a real option model of policy timing using a green social welfare as the objective, consisting of the standard Hotelling model of exhaustible resource extraction, and a stochastic state variable to capture uncertainties over the social costs of environmental damage. Analytic solutions are derived to show the implication of these uncertainties for policy adoption, and the results are presented: (i) a higher volatility of economic costs per emissions leads to a positive incentive for delaying removal in some bounds of uncertainties; (ii) amount of subsidies, pollution stocks, depletion of fossil fuel production and its marginal costs have negative impacts on the timing threshold, which implies that adopting currently is better than waiting; and (iii) discount rate increases the option value of delaying the policy. Our study provides a valuable framework to determine the energy and environmental policy timing with uncertainties for regulators.