Navigating the subsidy path to decarbonization under uncertainties

Abstract

The ongoing debate about the carbon subsidy regime focuses primarily on identifying the appropriate intended recipients and clarifying its role in sustainable operations. This paper assesses the effectiveness of the carbon subsidy regime by examining its impact on decarbonization incentives, profitability, sustainability, and welfare amidst uncertainties in innovation and demand. For that purpose, we develop models for cases where the government implements either the supply-side or the demand-side subsidy regime, as well as the benchmark model without any subsidy. Analysis of the equilibrium outcomes shows that subsidizing the firm (consumers) can effectively incentivize decarbonization innovation when the environmental coefficient is high (low). A key finding is that the supply-side subsidy regime could yield a win–win–win–win outcome for the government, the firm, consumers, and the environment; however, the demand-side subsidy regime may undermine sustainability despite enhancing profitability and welfare. Moreover, the government tends to subsidize consumers as the probability of successful decarbonization increases, whereas heightened demand uncertainty or consumers’ low-carbon preferences will prompt the government to subsidize the firm instead. We extend the model to the bilateral subsidy scenario, demonstrating that this regime may not guarantee a Pareto improvement because, in some cases, it reduces both profitability and sustainability. Notably, our main findings remain robust when: (i) The government has a finite subsidy budget, (ii) the government subsidizes the firm’s production cost instead of the investment cost, (iii) the probability of successful decarbonization is dependent on the firm’s investment efforts, or (iv) green and traditional products coexist in the market cannibalizing each other’s sales.