Substitution between biofuels and fossil fuels: Is there a green paradox? R. Quentin Grafton a , Tom Kompas a , Ngo Van Long b,n a Crawford School, Australian National University, Australia b CIREQ, CESifo, and Department of Economics, McGill University, Canada article info Article history: Received 31 August 2010 Available online 4 August 2012 Keywords: Biofuels subsidies The Green Paradox Climate change abstract We show that (i) subsidies for renewable energy policies with the intention of encouraging substitution away from fossil fuels may accentuate climate change damages by hastening fossil fuel extraction, and that (ii) the opposite result holds under some specified conditions. We focus on the case of subsidies for renewable resources produced under increasing marginal costs, and assume that both the renewable resources and the fossil fuels are currently in use. Such subsidies have a direct effect and an indirect effect working in opposite directions. The direct effect is the reduction in demand for fossil fuels at any given price. The indirect effect is the reduction in the current equilibrium price for fossil fuels, which tends to increase the amount of fossil fuels demanded. Whether the sum of the two effects will actually result in an earlier or later date of exhaustion of the stock of fossil fuels depends on the curvature of the demand curve for energy and of the supply curve for the renewable substitute. & 2012 Elsevier Inc. All rights reserved. 1. Introduction The need to reduce CO 2 emissions to combat climate change is widely acknowledged. According to standard economic theory the first best measure would be a carbon tax, and, as [27] succinctly stated, ‘‘at any time, the optimal price of carbon emissions should be equal to the present value of all future climate costs caused by present emissions, often called the social cost of carbon.’’ In the real world, however, policy makers are faced with many constraints on the choice of policy instruments and their levels, and consequently first best policies cannot be implemented. Governments, in particular, face political opposition to the introduction of efficient carbon taxes. A more politically acceptable time path of carbon taxes would be of the ‘‘ramp’’ variety: a government starts with a low tax rate, but commits to raise the tax to efficient levels in the future. As has been demonstrated (e.g. [41]), such time paths of carbon tax may induce profit-maximizing fossil resource owners to hasten the extraction of their resources, thus increasing carbon emissions in the near term. 1 Such an outcome has been termed a ‘‘Green Paradox’’ [42,43]. Sinn’s message is that in designing policies one must take into account supply responses by owners of fossil fuels. The link between climate change and the behavior of firms extracting fossil-fuel resources was explored by [39,40,47,28,46]. Sinclair [39] was among the first economists to explicitly consider climate change policies that would Contents lists available at SciVerse ScienceDirect journal homepage: www.elsevier.com/locate/jeem Journal of Environmental Economics and Management 0095-0696/$ - see front matter & 2012 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.jeem.2012.07.008 n Corresponding author. E-mail address: ngo.long@mcgill.ca (N. Van Long). 1 Long and Sinn [33] offered an analysis of how extractive firms respond to an anticipated time path of varying tax rate, but they did not explicitly mention the effect on CO 2 concentration levels. Journal of Environmental Economics and Management 64 (2012) 328–341