Substitution between Biofuels and Fossil Fuels: Is There a Green Paradox?

We show that (i) subsidies for renewable energy policies with the intention of encouraging substitution away from fossil fuels may accentuate climate change damages by hastening fossil fuel extraction, and that (ii) the opposite result holds under some specified conditions. We focus on the case of subsidies for renewable resources produced under increasing marginal costs, and assume that both the renewable resources and the fossil fuels are currently in use. Such subsidies have a direct effect and an indirect effect working in opposite directions. The direct effect is the reduction in demand for fossil fuels at any given price. The indirect effect is the reduction in the current equilibrium price for fossil fuels, which tends to increase the amount of fossil fuels demanded. Whether the sum of the two effects will actually result in an earlier or later date of exhaustion of the stock of fossil fuels depends on the curvature of the demand curve for energy and of the supply curve for the renewable substitute.