Targeting Green Subsidies

Prof. Richard Sweeney

Overview

  • Last class we compared taxes and subsidies for reducing emissions.
  • Punchline: subsidies can never achieve the efficient outcome.
  • But they are politically easier to implement than taxes, so they are widely used. That motivates studying how to design subsidies optimaly.

Subsidies involve more policy design than taxes

  • Pigouvian taxes involve relatively little policy design. Simply tax emissions at their marginal social cost.
  • Subsidies are more complicated. We need to decide:
    • What to subsidize (EVs, solar panels, wind turbines, etc)
    • How much to subsidize (fixed amount, % of price, etc)
    • Who gets the subsidy (all buyers, low-income buyers, etc)

Application: Electric Vehicles

Share of EVS

Source:EIA

Note: US lags behind other markets

Source:IEA

EVs are a central pillar of the energy transition

  • Reminder: Plan is to electrify everything.
    • And then decarbonize electricity.

Question: How should we subsidize EVs?

  • Who should get the subsidy? How much?
  • What criteria would you used to decide?

Subsidy targeting

Modest Goal: Cost-Effectiveness

Idea: Get the most EVs per dollar of subsidy (or hit some EV target at the lowest cost)

  • Government budgets are constrained
  • Want maximum environmental benefit per dollar
  • Poorly designed subsidies waste money

Metric:

\[\text{Cost per additional EV} = \frac{\text{Total subsidy spending}}{\text{Additional EVs induced}}\]

What Determines Subsidy Cost?

Key parameter: Demand elasticity

\[\varepsilon = \frac{\% \Delta \text{ in quantity}}{\% \Delta \text{ in price}}\]

Demand elasticity determines:

  1. How many additional EVs the subsidy induces
  2. How many people get subsidies who would have bought anyway

Marginal vs. Inframarginal Costs

Every subsidy hits two types of consumers:

Marginal effect (what we want):

  • Induces NEW purchases
  • People buy BECAUSE of the subsidy
  • These are “additional” EVs
  • Creates social benefit

Inframarginal effect (waste):

  • Subsidizes EXISTING demand
  • People who would have bought anyway
  • No change in behavior
  • Pure transfer, no social benefit

Problem: We can’t tell who is marginal vs. inframarginal – so everyone who buys an EV gets the subsidy

Visualizing the Problem

Defining Additionality

Additionality = Fraction of subsidized EVs that are marginal to the subsidy

\[\text{Additionality} = \frac{Q_s - Q_0}{Q_s} \approx \frac{\varepsilon \cdot s/P}{1 + \varepsilon \cdot s/P}\]

  • Demand elasticity (ε)
  • Size of subsidy (s)
  • Base price (P)

Higher |ε| → higher additionality → more cost-effective

Example: Which market segments to target?

Case 1: Tesla Purchases in California

Assumptions:

  • Average Tesla price: ~$80,000
  • Combined subsidy: $10,000 (12.5% of price)
  • % increase in quantity demanded = (|elasticity|) * (subsidy/price)
  • cost per car = (subsidy * Qs)/ (Qs - Q0)
Elasticity Additionality Cost per Additional EV ($000)
-1.5 (low) 16% $63.3
-2.5 (mid) 24% $42
-3.5 (high) 30% $32.9

Even with a high elasticity, 70% of Tesla subsidies are wasted on inframarginal buyers, and the cost per additional EV is $33k!

Case 2: Non-Tesla EVs in California

Assumptions:

  • Average non-Tesla EV price: ~$35,000
  • Combined subsidy: $10,000 (29% of price)
Elasticity Additionality Cost per Additional EV ($000)
-1.5 (low) 30% $33.3
-2.5 (mid) 42% $24
-3.5 (high) 50% $20

Lower-priced vehicles have better cost-effectiveness, but total cost per additional EV close to the price of a car itself!

Policy Implication: Who to Target?

To maximize cost-effectiveness, target:

1. Lower-priced vehicles

  • Higher subsidy as % of price
  • More elastic demand

2. More price-sensitive consumers

  • Lower-income households
  • More responsive to subsidies

To date EV subsidies have not been equiable

Average EV Credit per Tax Return, By Income Level

Source: Davis

Targeting emissions reductions

We don’t actually care about the number of EVs, but about emissions reductions they provide.

  • CO2 taxes penalize exactly the margin of the relevant externality.
    • If a car pollutes more, it’s cost to drive goes up more.
    • People buy less / use them less, and emissions go down.
  • Green subsidies work through substitution: CO2 emitting goods become relatively more expensive, so people buy less / use less.
  • This only works well if the green goods subsidized are really close substitutes for polluting goods.

Subsidy Targeting Summary

  • The social optimum amount of EV’s is surely higher than current levels.
    • Petroleum externalities are largers than electricity externalities (in most places)
    • We need to decarbonize transportation to meet climate goals.
  • The optimal policy would be to put Pigouvian taxes on gasoline.
    • This would hit on both the extensive margins (what cars people buy) and intensive margina (how much they drive).
  • Instead policymakers have opted to subsidize the EV transition.
  • This will be expensive, but some subsidies are more cost-effective than others.
    • Targeting lower-priced vehicles and more price-sensitive consumers improves cost-effectiveness.
    • Targetting subsidies geographically to areas with cleaner grids and higher pollution damages would also better target the environmental benefits.