Carbon Abatement in the Fuel Market with Biofuels: Implications for Second-Best Policies

A carbon tax would penalize carbon intensive fuels like gasoline and shift fuel consumption to less carbon intensive alternatives like biofuels. Since biofuel production competes for land with agriculture, a carbon tax could raise land rents, divert land towards fuel production, and raise agricultural prices. This paper analyzes the welfare effect of a carbon tax on fuel with gasoline and biofuel as available fuel choices, in the presence of a labor tax and biofuel subsidy. The second-best optimal carbon tax is also quantified. Findings show that when biofuels is part of the fuel mix, the carbon tax has a commodity price effect which arises from tax-induced changes in land rent. The commodity price effect could exacerbate or attenuate the tax interaction effect caused by higher fuel prices, depending on the elasticity of substitution between gasoline and biofuel, the price elasticity of miles demand, and the relative emissions intensity of gasoline and biofuel. Numerical results show that the commodity price effect affects the value of the second-best optimal carbon tax, and that the effect is greater if the elasticity of substitution between gasoline and biofuel is high, miles is more price inelastic, and the GHG intensity of biofuel is lower compared to gasoline. In addition the existence of a fixed biofuel subsidy leads to a greater divergence between the value of the second-best optimal carbon tax with or without biofuels. A carbon tax policy decreases GHG emissions and increases welfare, in contrast to a biofuel subsidy, which also decreases GHG emissions but at a net welfare loss.