Balancing Production and Carbon Emissions with Fuel Substitution

Murray Leclair, Emmanuel (2024): Balancing Production and Carbon Emissions with Fuel Substitution.

Abstract

The economic cost of carbon pricing depends on the ability and incentives of firms to switch towards cleaner fuels. Yet, many fundamental economic forces that drive firms' decisions to use different fuels are unobserved, causing significant uncertainty over the effectiveness of carbon policies. In this paper, I propose a new dynamic production model with multidimensional unobserved heterogeneity that underly technology differences and captures how firms' fuel choices respond to price changes. These differences cause heterogeneity in abatement costs, which generates heterogeneous responses to carbon pricing. Leveraging minimal assumptions about optimal input choice and the technology frontier, I quantify the model from a detailed panel of Indian steel establishments. Based on these estimates, implementing a carbon tax equivalent to 2,000 INR/ton (25 USD/ton) of carbon dioxide equivalent leads to a 70% reduction in emissions. But only 18% of this reduction comes from fuel-switching within existing firms. I find that the larger reductions come from reallocation of output across firms (58%) and costly reduction in aggregate output (24%). Substantial heterogeneity in the fuel efficiency of existing furnaces coupled with the limited geographical reach of natural gas pipelines towards high-emission firms explains the prevalence of output reallocation relative to fuel switching.

• Item Type: MPRA Paper
• Language: English
• Keywords: Firm dynamics, input choice, fuel efficiency, production function, climate change
• Subjects: H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H23 - Externalities ; Redistributive Effects ; Environmental Taxes and Subsidies; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L11 - Production, Pricing, and Market Structure ; Size Distribution of Firms; L - Industrial Organization > L6 - Industry Studies: Manufacturing > L61 - Metals and Metal Products ; Cement ; Glass ; Ceramics; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q4 - Energy > Q41 - Demand and Supply ; Prices; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics > Q52 - Pollution Control Adoption and Costs ; Distributional Effects ; Employment Effects

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