Economic Development and Environmental Sustainability
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2011 3rd Issue: WB: Under What Conditions Does a Carbon Tax on Fossil Fuels Stimulate Biofuels?

Time: Aug. 17, 2011      Source: IEEPA

Introduction

Climate change is one of the greatest challenges the global community faces today. Anthropogenic emissions of greenhouse gases (GHG) are the main culprit behind climate change (IPCC, 2007). One way of mitigating GHG emissions is to reduce the combustion of fossil fuels. This can be achieved in a number of ways such as by reducing end-use energy service (e.g., heat, light) demand through price increase, by reducing final energy (e.g., electricity, gasoline) without curtailing delivery of energy services through efficiency improvements and by substituting fossil fuels with non-fossil energy sources.

The transport sector is one of the main contributors to GHG emissions in many countries around the world (IEA, 2009). This sector does not offer many cost-effective alternatives to reduce GHG emissions. Biofuels is one of the options. While some life cycle analyses have cast doubt on the net GHG emission reduction potential of biofuels (Searchinger et al., 2008; Fargione et al., 2008), more than forty countries around the world have introduced mandates or set targets for biofuels (Timilsina and Shrehtha, 2010). Several developed countries are continuing to push forward with policies that aim at increasing the share of biofuels in the transportation fuel mix (OECD, 2008).

Long-term energy import substitution is another driving factor for biofuel promotion. For example, many Sub-Saharan African countries depend entirely on imports for meeting their transportation fuel demand and are thus exposed to the impacts of fuel price volatility on the cost of imports. These countries have abundant arable land resources that can be utilized to produce biofuel feedstock (Mitchell, 2010) in order to reduce their dependency on petroleum imports.

Despite recent efforts to promote biofuels, the current share of biofuels in the global energy mix for transportation is only around 2 percent on energy equivalence basis.3 One reason for this low market penetration4 is that the price of fossil fuels does not include its negative external costs (e.g., environmental damage) to society. Particularly in the context of climate change mitigation, this could be addressed by imposing a carbon tax on fossil fuels. However, how much a carbon tax would change the relative economics of biofuels and its penetration in the energy supply mix is an empirical question.

During the last two decades, a plethora of research both on carbon taxation and on biofuels has been produced. This literature spans a wide range of issues, methodologies and disciplines, and a detailed review is beyond the scope of this paper. A number of studies use either general equilibrium or partial equilibrium models that incorporate biofuels, to simulate climate change mitigation policies. For instance, Janssen and de Vries (2000) simulate different GHG mitigation policies, such as a carbon tax in the energy system model TIME that includes biofuels, to estimate the costs of stabilizing the CO2 concentration in the atmosphere at 550 ppmv. However, the partial equilibrium approached employed in the TIME model does not account for economy-wide feedback effects of a carbon tax. Plevin and Mueller (2008) develop a bottom-up model to calculate the effects of a CO2 tax and other emission policies on the costs of producing ethanol from corn, but also their model is partial equilibrium, and the study can therefore not account for the spill-over effects of carbon policies on other sectors of the economy. McCormick and K?berger (2005) identify the Swedish carbon tax as a facilitating factor for the expansion of bioenergy in the town of Enk?ping, but such a case study does not Despite recent efforts to promote biofuels, the current share of biofuels in the global energy mix for transportation is only around 2 percent on energy equivalence basis.3 One reason for this low market penetration4 is that the price of fossil fuels does not include its negative external costs (e.g., environmental damage) to society. Particularly in the context of climate change mitigation, this could be addressed by imposing a carbon tax on fossil fuels. However, how much a carbon tax would change the relative economics of biofuels and its penetration in the energy supply mix is an empirical question.

During the last two decades, a plethora of research both on carbon taxation and on biofuels has been produced. This literature spans a wide range of issues, methodologies and disciplines, and a detailed review is beyond the scope of this paper. A number of studies use either general equilibrium or partial equilibrium models that incorporate biofuels, to simulate climate change mitigation policies. For instance, Janssen and de Vries (2000) simulate different GHG mitigation policies, such as a carbon tax in the energy system model TIME that includes biofuels, to estimate the costs of stabilizing the CO2 concentration in the atmosphere at 550 ppmv. However, the partial equilibrium approached employed in the TIME model does not account for economy-wide feedback effects of a carbon tax. Plevin and Mueller (2008) develop a bottom-up model to calculate the effects of a CO2 tax and other emission policies on the costs of producing ethanol from corn, but also their model is partial equilibrium, and the study can therefore not account for the spill-over effects of carbon policies on other sectors of the economy. McCormick and K?berger (2005) identify the Swedish carbon tax as a facilitating factor for the expansion of bioenergy in the town of Enk?ping, but such a case study does not also run a scenario in the sensitivity analysis where a carbon tax is imposed only on gasoline and diesel. The model produces a large number of results including impacts on GDP, sectoral outputs, household income and consumption, government revenue and expenditure, international trade of goods and services, demand for intermediate consumption and capital formation at country levels. However, for purpose of clarity and comprehensiveness, we present only key results, such as GDP, biofuel demand, agriculture outputs at the global and regional level.

Our study finds that such carbon tax, applied with lump-sum redistribution of revenues, does not in itself stimulate production of biofuels. This is because other opportunities for GHG mitigation, notably reduced coal use in the power sector, will be more cost-effective; in addition, the carbon tax will have negative economy-wide consequences (especially for fossil fuel producing and energy- and carbon-intensive manufacturing industries), and these effects in turn will reduce total demand for all fuels. However, if part of carbon tax revenue is used to subsidize biofuels, the combined effect of the carbon tax and biofuel subsidy would lead to a substantial increase in biofuel penetration. Although such a subsidy would cause further contraction of the economy by moving away from the cost-effective solution using the carbon tax alone, the additional output contraction is found to be small, in particular as compared to the negative aggregate output effect of a carbon tax alone. This finding is broadly similar to that of studies by Weber et al. (2005) and Barker et al. (2008), which find that if carbon tax revenue is used to finance GHG mitigation activities, such as improvement of energy efficiency, the environmental impacts of carbon tax is stronger as compared to a situation where carbon tax revenues are recycled for other purposes (e.g., lump-sum rebate to households).

The remainder of the paper is structured as follows. Section 2 provides a brief description of the CGE model developed for the study followed by presentation of key simulation results in Section 6

3. Section 4 highlights results of some sensitivity analysis followed by discussion on policy insight in Section 5. Finally, conclusions are presented in Section 6.

More information will be available on:

http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/Rendered/PDF/WPS5678.pdf

Source: World Bank

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