March 6, 2011

Optimal Carbon Tax with a Dirty Backstop - Oil, Coal, or Renewables?

by Frederick van der Ploeg and Cees Withagen

- Optimal climate policy is studied. Coal, the abundant resource, contributes more CO2 per unit of energy than the exhaustible resource, oil. We characterize the optimal sequencing oil and coal and departures from the Herfindahl rule. "Preference reversal" can take place. If coal is very dirty compared to oil, there is no simultaneous use. Else, the optimal outcome starts with oil, before using oil and coal together, and finally coal on its own. The "laissez-faire" outcome uses coal forever or starts with oil until it is no longer profitable to do so and then switches to coal. The optimum requires a steeply rising CO2 tax during the oil-only phase and a less steeply rising CO2 tax during the subsequent oil-coal and coal-only phases to avoid the abrupt switch from oil to coal thus leaving a lot of oil in situ.

van der Ploeg, F. and C. Withagen (2011). "Optimal Carbon Tax with a Dirty Backstop - Oil, Coal, or Renewables?" CESifo Working Paper No. 3334, Jan 2011.