Optimal policies for decarbonization via carbon capture: Tax, subsidize, or both?

Abstract

This study examines how governments design decarbonization policies using emission taxes, carbon capture and storage subsidies, or the combination of both. We develop a two-stage model in which the government first chooses policy instruments to maximize welfare, while carbon-intensive firms respond by selecting production and abatement levels. We then use Monte Carlo simulations to assess how simultaneous variation in model parameters affects optimal policies. The analytical results reveal that taxes and subsidies are strategic substitutes—raising one calls for reducing the other. The optimal policy mix depends on pollution intensity and damage. High intensity favors a tax-only regime, whereas low intensity calls for subsidies alone or a mix of both, depending on marginal damage. These results highlight the need for policymakers to align policy instruments with environmental parameters. The simulation results show the emergence of a tax-only regime where tax rates are closely tied to marginal damages.