Climate Policy and The Energy Transition

Abstract

This paper studies the macroeconomic dynamics of climate policy in a multi-sector dynamic general equilibrium model with renewable and non-renewable energy, sector-specific capital adjustment frictions, household energy demand, and endogenous fossil resource dynamics. The central mechanism is that decarbonization requires reallocating energy use and installed capital: fossil energy demand can contract immediately, while renewable capacity and abatement adjust only gradually. The analysis delivers four results. First, gradual policy implementation sharply reduces transition costs: relative to immediate implementation, gradual emissions caps improve welfare by 2.26 percentage points under comprehensive regulation and by 5.06 percentage points under firm-only regulation. Second, renewable energy subsidies and non-renewable energy taxes support renewable capital accumulation and reduce, but do not eliminate, the welfare cost of front-loaded tightening. Third, sectoral coverage changes the welfare ranking across implementation speeds. Firm-only regulation performs better under gradual implementation because it shields utility-relevant household energy services, but becomes nearly as costly as the carbon-price-only transition under immediate implementation. Fourth, endogenous fossil exploration and stock-dependent extraction costs transmit climate policy into lower extraction, fewer discoveries, and a declining shadow value of reserves, providing a structural mechanism for stranded fossil assets. The results show that deep decarbonization can be achieved at substantially lower macroeconomic cost when policy manages the speed and incidence of energy-capital reallocation.