Climate Policy and the Optimal Extraction of High- and Low-Carbon Fossil Fuels

We study how restricting CO2 emissions affects resource prices and depletion over time. We use a Hotelling-style model with two nonrenewable fossil fuels that differ in their carbon content (e.g., coal and natural gas) and that are imperfect substitutes in final good production. We study both an unexpected constraint and an anticipated constraint. Both shocks induce intertemporal substitution of resource use. When emissions are unexpectedly restricted, it is cost-effective to use high-carbon resources relatively more (less) intensively on impact if this resource is relatively scarce (abundant). If the emission constraint is anticipated, it is cost-effective to use relatively more (less) of the low-carbon input before the constraint becomes binding, in order to conserve relatively more (less) of the high-carbon input for the period when climate policy is active in case the high-carbon resource is relatively scarce (abundant)