Under What Conditions Does a Carbon Tax on Fossil Fuels Stimulate Biofuels?

A carbon tax is an efficient economic
instrument to reduce emissions of carbon dioxide released
from fossil fuel burning. Its impacts on production of
renewable energy depend on how it is designed --
particularly in the context of the penetration of biofuels
into the energy supply mix for road transportation. Using a
multi-sector, multi-country computable general equilibrium
model, this study shows first that a carbon tax with the
entire tax revenue recycled to households through a lump-sum
transfer does not stimulate biofuel production
significantly, even at relatively high tax rates. This
reflects the high cost of carbon dioxide abatement through
biofuels substitution, relative to other energy substitution
alternatives; in addition, the carbon tax will have negative
economy-wide consequences that reduce total demand for all
fuels. A combined carbon tax and biofuel subsidy policy,
where part of the carbon tax revenue is used to finance a
biofuel subsidy, would significantly stimulate market
penetration of biofuels. Although the carbon tax and biofuel
subsidy policy would cause higher loss in global economic
output compared with the carbon tax with lump sum revenue
redistribution, the incremental output loss is relatively small.