Optimal climate policy as if the transition matters

The transition to a low-carbon economy is constrained by frictions in scaling up clean energy and phasing out existing fossil-fuel assets. This paper studies what optimal climate policy looks like in these circumstances, with the authors exploring the tension between the urgent need for rapid greenhouse gas emissions reductions, on the one hand, and concerns about the feasibility and cost of achieving them, on the other. The authors model a scenario in which reducing emissions requires capital to be reallocated from dirty to clean energy production under real-world constraints. A central feature is the introduction of heterogeneous dirty capital – i.e. capital whose emissions intensity varies depending on the fuel and technology used – which the authors calibrate using detailed firm-level data. This allows the authors to identify a highly emissions-intensive subset of assets: the ‘dirty tail’. The model shows that large emissions reductions can be achieved by targeting the early retirement of the dirty tail, rather than reducing all fossil capital proportionately. The authors’ modelling includes limits to how quickly clean capital can be scaled up and dirty capital can be retired. This implies that the transition cannot occur instantaneously, creating capital inertia that constrains the speed of emissions reductions. The authors calibrate these adjustment costs on recent episodes of rapid energy system expansions and coal phase-outs. The main result is that, despite these constraints, the optimal transition to a low-carbon economy is rapid and front-loaded. Emissions fall steeply in the near term, driven by immediate disinvestment from the assets in the dirty tail, followed by a more gradual phase in which remaining dirty capital is allowed to depreciate, while clean capital continues to expand. Overall, the paper shows that taking transition constraints seriously changes how emissions reductions are achieved, emphasising the composition and timing of capital reallocation. However, these constraints do not overturn the case for rapid decarbonisation. Instead, they point to the importance of targeted, early action on the most polluting assets, as well as action to ease bottlenecks in expanding clean capital. Key points for decision-makers: Rapid reductions in global emissions are optimal climate policy, even when accounting for constraints on the speed of the transition. Global emissions should be halved in the next ten years. Early retirement of the most polluting assets (the ‘dirty tail’) allows large emissions cuts at low cost, even after accounting for the legal, institutional and political costs of doing so. Effective climate mitigation can, in principle, be achieved by targeting the concentration of emissions in the dirty tail. A globally harmonised carbon tax would be the most efficient way of achieving this, but difficult in practice. Alternative effective policies at the international level include targeted finance and technology transfer to support early retirement of high-emissions assets in developing countries. Examples of this approach include the Just Energy Transition Partnerships under the Paris Agreement and coal transition vehicles. Alternative effective policies targeting the early retirement of the dirty tail at the national level include government-mandated phase-out schedules, reverse auctions, performance standards and feebate schemes. Easing bottlenecks on the clean side of the low-carbon transition will increase the pace of emissions reductions. Constraints on the rate of clean-capital expansion, arising from manufacturing capacity, supply chains, permitting and infrastructure, materially affect the pace of emissions reductions, especially after the dirty tail is eliminated. This highlights the importance of developing policies that relax these constraints, including support for manufacturing capacity, permitting reform, grid infrastructure and supply chains for critical materials. This is an update to the authors’ original working paper of the same name, which was first published in December 2022.