Working Paper Series no. 910: Environmental Subsidies to Mitigate Net-Zero Transition Costs

Energy transition requires a profound change in production processes by substituting polluting inputs for low-emission inputs. Without any particular expertise, firms must critically rely on the environmental goods and services sector (EGSS) to lower their carbon footprint. However, EGSS is still under-developed. For instance, in the European Union, it represents no more than 5.5% of GDP and 2.3% of total employment. Furthermore, it is highly concentrated, with net margins well above the average for all industries. Such a concentration results from high barriers to entry that prevent potential competitors from challenging incumbent firms. Last, the number of world environment-related patents has decreased since 2012. This means that an EGSS that is too small and insufficiently competitive will increase transition cost through a higher price for environment-related products and thus threaten the achievement of the Paris Agreement.

Motivated by these observations, we investigate how public subsidies can mitigate transition cost in promoting the development of EGSS. Our contribution is threefold.

First, we develop a nonlinear macro-climate model for the world economy featuring an endogenous market structure for the abatement good sector (or equivalently EGSS), with a clear distinction between changes in the production of existing goods (intensive margins) and changes in the variety of available goods supplied by new firms (extensive margins). By relying on explicit microfoundations and forward-looking agents, our model appropriately controls for the effects of policy measures through expectations, notably those related to climate change, which may imply permanent shifts in macroeconomic time series.

Second, we estimate this macro-climate model using full information methods. A nonlinear estimation is deemed necessary to account for unbalanced growth dynamics originating from climate change. To this end, we rely on the extended path solution method to numerically solve the model and an inversion filter to calculate the likelihood function. Finally, using Bayesian techniques, we describe the joint fluctuations of five world’s macroeconomic and climate-related time series from 1961 to 2018.

Third, we use the model to generate projections to the end of the 21st century. We consider two alternative climate scenarios in line with the International Panel on Climate Change. The first scenario assumes that there are no environmental policies, resulting in a continuous increase in carbon emissions (“laisser-faire scenario”). The second scenario assumes that carbon neutrality is reached in 2060 thanks to the introduction of a carbon tax (“Paris Agreement scenario”). Following the introduction of a carbon tax aiming at fulfilling the Paris agreement, producing firms seek to reduce their emissions by purchasing abatement goods. The prospect of future high profits in the abatement good sector boosts firms’ market value and, through free-entry conditions, incentivizes prospective entrants to create startups. The number of firms increases, and the resulting competition pushes prices down. However, the carbon tax and the transfer of resources from the production sector to the abatement goods sector are expected to have a recessive impact on the economy. We thus propose two subsidy experiments designed to mitigate the cost of the transition: a subsidy to existing firms in the abatement good sector and  a subsidy that is optimally shared between existing firms and startups in a way that maximizes social welfare.

As suggested by the figure above, we find that the Paris Agreement scenario would lead to a cumulative world GDP loss of $266 trillion from 2019 to 2060 relative to the laissez-faire scenario (i.e., an average annual loss of $6.3 trillion, or equivalently 6% of 2022 world GDP). Public subsidies, fully financed by the carbon tax, can reduce this loss substantially by fostering competition and lowering the selling price of abatement goods. A subsidy policy targeting startups is particularly efficient as it quickly lowers the cost of adopting green production technologies. Following the optimal allocation scheme, i.e. with 60% of carbon tax revenues allocated to startups and 40% to existing firms, the cumulative loss of GDP would fall to $145 trillion between 2019 and 2060. Hence, the optimal subsidy would reduce the GDP loss by $121 trillion, or equivalently $2.9 trillion each year. Note that in this scenario, the carbon tax would increase to $150 per ton of CO2 by 2040 and $400 by 2060, the abatement price would be divided by more than 2.5, and the numbers of firms/varieties in the abatement good sector would substantially increase.

Interestingly, the largest gains are made during the first 10 to 20 years of the policy, as 3the subsidies allow the abatement good price to be drastically reduced and encourage the entry of new firms into the abatement good sector. Therefore, by accelerating the development of the abatement good sector and by reducing the costs associated with the net-zero emissions objective by 2060, the subsidy policy has a double benefit, which substantially mitigates climate transition costs