Taxing CO2 and subsidising biomass: analysed in a macroeconomic and sectoral model

This paper analyses the combination of taxes and subsidies as an instrument to enable a reduction in CO2 emission. The objective of the study is to compare recycling of a CO2 tax revenue as a subsidy for biomass use as opposed to traditional recycling such as reduced income or corporate taxation. A model of Denmark’s energy supply sector is used to analyse the effect of a CO2 tax combined with using the tax revenue for biomass subsidies. The energy supply model is linked to a macroeconomic model such that the macroeconomic consequences of tax policies can be analysed along with the consequences for specific sectors such as agriculture. Electricity and heat are produced at heat and power plants utilising fuels which minimise total fuel cost, while the authorities regulate capacity expansion technologies. The effect of fuel taxes and subsidies on fuels is very sensitive to the fuel substitution possibilities of the power plants and also to the extent to which expansion technologies have been regulated. It is shown how a relatively small CO2 tax of 15 US$/tCO2 and subsidies for biomass can produce significant shifts in the fuel input-mix, when the expansion of production capacity is regulated to ensure a flexible fuel mix. The main finding is that recycling to biomass use will reduce the level of CO2 tax necessary to achieve a specific emission reduction. Policies to ensure a more intensive use of such relatively expensive renewable energy sources as biomass could be implemented with only small taxes and subsidies.