Memorandum, Department of Economics, University of Oslo 04/2012
Countries with an active climate policy often use several other policy instruments in addition to a price on carbon emissions, such as subsidies to renewable energy. An obvious reason for subsidizing alternatives to carbon energy is that the price of carbon emissions is too low. The paper derives implications for a second-best climate policy if for some reason the price of carbon emissions is lower than the Pigovian level, and also discusses reasons policy makers might have for setting the tax rate at an inefficiently low level. Even if the current tax rate is optimally set, governments cannot commit to future tax rates. In some cases this inabilty to commit may justify subsidies to investments in renewable energy.